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These 4 Measures Indicate That Orion Engineered Carbons (NYSE:OEC) Is Using Debt Extensively

Simply Wall St

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Orion Engineered Carbons S.A. (NYSE:OEC) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Orion Engineered Carbons

What Is Orion Engineered Carbons's Debt?

The chart below, which you can click on for greater detail, shows that Orion Engineered Carbons had US$666.1m in debt in September 2019; about the same as the year before. However, it also had US$58.6m in cash, and so its net debt is US$607.5m.

NYSE:OEC Historical Debt, November 13th 2019

How Healthy Is Orion Engineered Carbons's Balance Sheet?

The latest balance sheet data shows that Orion Engineered Carbons had liabilities of US$290.9m due within a year, and liabilities of US$763.2m falling due after that. Offsetting these obligations, it had cash of US$58.6m as well as receivables valued at US$258.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$736.9m.

This is a mountain of leverage relative to its market capitalization of US$1.17b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With a debt to EBITDA ratio of 2.4, Orion Engineered Carbons uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 7.3 times its interest expenses harmonizes with that theme. Unfortunately, Orion Engineered Carbons's EBIT flopped 15% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Orion Engineered Carbons's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Orion Engineered Carbons's free cash flow amounted to 31% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Orion Engineered Carbons's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Orion Engineered Carbons stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Orion Engineered Carbons's dividend history, without delay!

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.